By Mark Churchmichael, Head of Compliance & Tax

A founder once told me: “We gave our early employees options worth millions… and one of them had to borrow money just to pay the tax.” This happens far more often than people realise.

Employee Share Option Plans (ESOPs) and Employee Share Schemes (ESS) are one of the best tools for attracting talent, retaining key staff and aligning incentives with growth. But the tax outcome depends entirely on timing.

Employees can end up paying tax when options are granted, when options are exercised and when shares are sold. Or sometimes all three.

The rules sit inside Division 83A of the Income Tax Assessment Act 1997, and the differences between the regimes are enormous.

Let’s break it down.

1. Grant of Options – Usually No Immediate Tax

Most ESOPs issue options (rights to acquire shares) rather than shares themselves. If the scheme qualifies for tax deferral, there is generally no tax at grant. However, if the scheme is taxed upfront, the employee is taxed immediately on the discount received.

Example – Upfront ESS

Employee receives:

• 10,000 options
• Exercise price: $1
• Market value of share at grant: $2

Discount:

$1 × 10,000 = $10,000

The $10,000 is treated as employment income.

If the employee is on the top marginal tax rate (47% including Medicare in 2026):

Tax payable ≈ $4,700

Trap: The employee pays tax even though they have received no cash.

2. Vesting – Usually not a Tax Event for Options

Many employees assume tax occurs when options vest. Under the current ESS rules for options, the taxing point for deferred schemes generally occurs at exercise rather than vesting, provided the scheme satisfies the deferral conditions.

However, earlier taxing points can still occur if:

• the real risk of forfeiture ends, or
• disposal restrictions lift, or
• the employee leaves employment, or
• 15 years pass since grant.

This is known as the Deferred Taxing Point.

Trap: Employees often assume vesting = tax. In well-structured start up option plans, this usually isn’t the case.

3. Exercising Options – Where Income Tax Often Hits

For many Australian ESOPs, the tax event occurs when the option is exercised. The taxable amount is the ESS discount:

Market value of share at exercise – Exercise price = Taxable income

This amount is taxed as employment income, not capital gains.

Example – Deferred ESS

Employee receives:

• 10,000 options
• Exercise price: $1

Three years later:

Share value = $5

Discount:

($5 − $1) × 10,000 = $40,000

Taxed as salary income.

If the employee sits in the 37% tax bracket + 2% Medicare:

Tax payable ≈ $15,600

At this point, the market value at exercise becomes the CGT cost base.

Trap: Employees can face a large tax bill when exercising options, even though the shares may still be illiquid.

4. The 30-Day Rule

If the shares are sold within 30 days of the taxing point, the ESS rules treat the sale price as the market value.

This means:

• the ESS income equals the actual sale proceeds, and
• there may be little or no capital gain.

This rule is often used in IPO or acquisition exits.

5. Exit Event – Capital Gains Tax Applies

Once shares have been acquired through exercising options, future growth is taxed under Capital Gains Tax (CGT).

Example:

Employee:

• Exercises options when shares worth $5
• Later sells shares for $20

Capital gain:

$20 − $5 = $15 per share

If held more than 12 months after exercise, the 50% CGT discount applies.

For 10,000 shares:

Gain = $150,000

Taxable after discount = $75,000

At a 37% marginal rate:

Tax ≈ $27,750

6. The Start Up ESS Concession (The Best Outcome)

Australia provides a powerful concession for eligible start up companies.

Under this regime:

• No tax at grant
• No tax at vesting
• No tax at exercise

Instead, tax occurs only when the shares are sold, and it is treated entirely as capital gains.

Typical eligibility conditions include:

• company is unlisted
• incorporated less than 10 years
• group turnover below $50 million
• exercise price ≥ market value at grant
• employee holds <10% ownership

Example – Start Up Concession

Employee receives:

• 20,000 options at $1 strike
• Exit price $15

Gain:

($15 − $1) × 20,000 = $280,000

After 50% CGT discount:

Taxable gain = $140,000

At 37% tax:

Tax ≈ $51,800

Without the start up concession, some of that $280k gain might have been taxed as salary income years earlier.

7. Common ESOP Tax Traps

Trap 1 – Tax without liquidity

Income tax may arise before an exit event.

Trap 2 – Exercising too early

Exercising options early may create income tax years before liquidity.

Trap 3 – Incorrect valuations

Trap 4 – Losing the start up concession

If the option exercise price is below market value, the start up concession can fail.

Trap 5 – The 10% ownership rule

Employees holding >10% ownership or voting power cannot access ESS concessions.

Final Thought

Equity compensation can create life-changing wealth.

But in Australia, the timing of tax matters more than the size of the grant.

The difference between:

• taxed upfront
• tax-deferred
• start up concession

can mean paying tax years before liquidity, or only after a successful exit.

Good ESOP design can make the difference between a motivational equity plan and a tax nightmare.

Did you find these insights valuable? Follow Stewart & Smith Advisory for more expert guidance on navigating the complexities of business finance.